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FAS 159: The Fair Value Option On February 15, 2007 FAS 159 was released. This Statement permits entities to choose to measure many recognized financial instruments at fair value. While the stated goal of the Statement was to simplify financial reporting and provide a means to reduce income statement volatility, for many community banks the opposite result occurs. See the Analysis section at the end of this report for details. Overview The fair value option applies to all entities that elect its provisions. Eligible items include: 1 Recognized financial assets and liabilities except: a. Investment in a subsidiary required to be consolidated. b. Interest in a variable interest entity required to be consolidated. c. Various benefit plans and obligations. d. Financial assets and liabilities recognized as leases. e. Deposit liabilities withdrawable on demand. f. Instruments classified as a component of shareholders equity. 2 Firm commitments involving only financial commitments. 3 Nonfinancial insurance contracts and warranties. 4 Certain host financial instruments separated from embedded nonfinancial derivatives. The fair value option permits all entities to measure eligible items at fair value at specified election dates. Unrealized gains and losses due to fair value changes are reported in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. The fair value option: 1 May be applied instrument by instrument. 2 Is irrevocable. 3 Is applied only to entire instruments and not to only specified risks, specific cash flows or portions of instruments. An entity may decide to elect the fair value option for each eligible item on its election date, or the election may automatically occur according to a preexisting policy for specified types of eligible items. Election dates include the date: 1 The entity first recognizes the eligible item. 2 The entity enters into an eligible firm commitment. 3 Financial assets that have been reported at fair value with unrealized gains and losses included in earnings because of specialized accounting principles cease to qualify for that specialized accounting. 4 That specific accounting treatment for an investment in another entity changes. 5 An event requires an eligible item to be measured at fair value, but does not require fair value measurement at subsequent reporting dates (such as business combinations, consolidations/deconsolidations and certain modifications of debt).

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Instrument-by-instrument application allows the fair value method to be elected for a single eligible item without electing it for other identical items with the following four exceptions: 1 If multiple advances made to one borrower under a line of credit or construction borrowing lose their identity and become part of a larger loan balance, the fair value option is available only to the larger balance and not to each advance individually. 2 If fair value option is applied to an investment accounted for under the equity method, all eligible financial interests in the same entity must apply fair value. 3 If fair value is applied to eligible insurance contracts, it shall be applied to all claims and obligations under that contract. 4 If fair value is applied to eligible base insurance contracts, it shall be applied to all concurrently or subsequently issued riders. The fair value option need not be applied to all instruments issued or acquired in a single transaction. For example, investors may choose to apply the fair value option to only some shares or bonds issued or acquired in a single transaction. A financial instrument that is a single contract, such as a loan, may not be separated into parts for purposes of applying the fair value option. In contrast, a loan syndication arrangement may result in multiple loans to the same borrower by different lenders. Each of these loans is a separate instrument, and the fair value option may be elected for some of those loans, but not others. Presentation and Disclosures Entities shall report assets and liabilities measured at fair value pursuant to this Statement in a manner that separates the reported fair values from the carrying amounts of similar items. To do so, the entity shall either present the aggregate of fair value and non-fair-value amounts in the same line item and parenthetically disclose the fair value amount, or present two separate line items to display fair value and non-fair-value carrying amounts. The principal disclosure objectives are to facilitate comparison between entities choosing different measurement attributes for similar assets and liabilities and between assets and liabilities in the financial statements of an entity that selects different measurement attributes for similar assets and liabilities. The disclosure requirements are expected to allow financial statement users: 1 To understand managements reasons for electing fair value option. 2 To understand how changes in fair value affect earnings for the period. 3 To observe the same information about certain items that would have been disclosed if the fair value option had not been elected. 4 To understand differences between fair values and contractual cash flows for certain items. As of each date for which a statement of financial position is presented, entities shall disclose: 1 Managements reasons for electing a fair value option for each eligible item or group of similar items. If the fair value option is elected for some, but not all eligible items within a group of similar items:

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a. A description of the similar items and reasons for the partial election. b. Information useful to understand how the group of similar items relates to individual line items in the statement of financial position. 2 For each line item in the statement of financial position that includes items for which the fair value option has been elected: a. Information to help users understand how each line item relates to major categories of assets and liabilities presented in accordance with FAS 157s disclosure requirements. b. The aggregate carrying amount in each line item that is not eligible for the fair value election. 3 The difference between the aggregate fair value and the aggregate unpaid principal balance of: a. Loans and long-term receivables. b. Long-term debt instruments. 4 For loans held as assets for which the fair value option has been elected: a. Aggregate fair value of loans 90 days or more past due. b. If the entitys policy is to recognize interest income separately from other changes in fair value, the aggregate fair value of nonaccrual status loans. c. The difference between the aggregate fair value and the aggregate unpaid principal balance for loans that are 90 days or more past due, in nonaccrual status, or both. For each period in which an income statement is presented, entities shall disclose the following about items for which the fair value option has been elected: 1 For each line item in the statement of financial position, the amount of gains and losses from fair value changes included in earnings during the period, and in which line in the income statement those gains and losses are reported. 2 Information concerning the measurement of interest and dividends from investments for which the fair value option has been elected. 3 For loans and other receivables held as assets: a. Estimated amount of gains and losses attributable to instrument-specific credit risk. b. How the gains and losses attributed to changes in instrument-specific credit risk were determined. 4 For liabilities with fair values significantly affected during the reporting period by changes in the instrument-specific credit risk: a. Estimated amount of gains and losses attributable to instrument-specific credit risk. b. Qualitative information about the reason for those changes. c. How the gains and losses attributable to instrument-specific credit risk were determined. Annually, the entity shall disclose the methods and significant assumptions used to estimate the fair values of items for which the fair value option has been elected. The FAS 159 disclosure requirements do not eliminate disclosure requirements included in other GAAP pronouncements.

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This Statement is effective for fiscal years beginning after November 15, 2007, with early adoption possible in certain circumstances. Transition provisions permit application to eligible items existing at the effective or early adoption date. Consult your accountant for further information. Analysis While designed to offer a simpler, less burdensome alternative to hedge accounting, FASB has instead created another way for the unwary to become ensnared in accounting complexities. While it is true that entities electing FAS 159 fair value option for fixed rate commercial loans would no longer be required to perform effectiveness testing, the news is not all good for community banks. Consider these few issues: 1 While hedge accounting may be terminated at any time, the fair value option is irrevocable. 2 While hedge accounting may be elected at any time, the fair value option may only be elected at specific election dates. 3 In order to implement the fair value option, the bank still must grapple with designing a robust methodology to allow the calculation and decomposition of fair values, including changes due to credit. 4 Electing the fair value option does not free you from complying with the documentation, reporting and disclosure requirements of FAS 133. 5 Hedge accounting may be implemented for a specifically identified portion or percentage of a loan, while the fair value option is only available for the entire asset. Perhaps the most dangerous aspect of FAS 159 is the restriction on applying fair value to the entire instrument only and not to specified risks, specific cash flows or portions of the instrument. What this means is that unlike hedge accounting under FAS 133, the bank cannot hedge only the risk related to the benchmark interest rate, which most accurately tracks the market value changes of a properly selected hedge, but must instead include other risks such as credit risk. So if the borrowers credit quality were to worsen, the bank could be faced with increased income statement volatility even if the selected hedge were accurately tracking interest rate changes. Recommendation At this time we are not recommending adoption of FAS 159 as an alternative to hedge accounting under FAS 133.
Wondering how these rules apply to you? Call us today for a free analysis and consultation at 1.800.971.1378. Well help you understand these complex standards and then advise you on the right approach for your financial situation ultimately helping you maximize your financial potential.